Public expenditure

Public spending is spending by central and local government and spending associated with state owned enterprises. Public spending is a relatively large and stable component of aggregate demand in most advanced economies, typically contributing between 30 to 40% to economic activity.

As a proportion of GDP, public spending has increased over time, and tends to spike at times of military conflict, recession, and national crises such as the financial crisis of 2008-9 and the recent COVID-19 pandemic.

Current and capital expenditure and transfer payments

Current expenditure

Current public spending is used to fund the wages of public sector employees, and other operating costs associated with running government departments.

Capital spending

Capital spending is used to fund capital projects including items such as new school buildings and hospitals, equipment for defense and expenditure on infrastructure.

Transfer payments

Transfer payments are payments between a person, group, or organisation to another person which does not involve the exchange of goods or services.

The most common transfer payments (shortened to ‘transfers) are between the state and individuals in the form of benefits, grants or subsidies.

In macroeconomic terms, transfers are commonly between the government and households. Transfers add to personal incomes but not to national income.

Reasons for the changing size and composition of public expenditure

The size of public expenditure can be measured in several ways, including in terms of its share of GDP, its absolute size, and the amount spent per head of the population.

The pattern of public spending refers to where the expenditure goes in terms of different departments, such as education, healthcare, defense, or social spending, or in terms of the broad nature of spending in terms of public goods, merit goods and transfer payments.

Factors affecting either the size of the pattern include the following:

Changes in the size of an economy

As an economy's real GDP per capita grows the pattern of consumer spending shifts away from basic essentials towards luxury goods and services. Underlying this is the differences that exist between the income elasticity of various goods and services.

For example, basic necessities may have a negative income elasticity (technically, inferior goods), meaning that demand for them falls away as incomes rise.

On the other hand, demand for consumer goods and many services increase by a greater proportion than the initial increase in income (technically, normal goods).

So, as economies grow and develop both the size and pattern of government spending will adjust. For example, as people travel more, and as more consumer goods are transported, demand for an efficient transport network increases. This means that more public spending is likely to be allocated towards transport infrastructure.

Similarly, the need for more energy supplies might see government spending more on energy infrastructure.

As an economy grows the pattern of employment also changes, with more demand for skilled and well educated workers - again, which means there is an increased demand for healthcare and education, and for housing in urban areas. Economic growth often leads to urbanisation, which creates its own need for public spending.

Health shocks

The COVID-19 pandemic required considerable amounts of public spending both in terms of the allocation of resources to vaccinations and treatments, but also in terms of support for those forced to isolate during lockdowns. This also meant that other forms of treatment were put on hold, meaning that it might take many months to clear the backlog of patients waiting for treatment.

Demographic factors

Similarly, both an aging population, and a population with a large number of people under working age, put extra pressure on public services such as healthcare - again, affecting both the level of spending and the distribution of spending.

Fiscal policy and policy priorities

If governments become more actively involved in an economy, the need for public spending may increase. For example, a fiscal stimulus to reduce poverty or to reduce inequality will require more resources, and will mean increases in the amount of spending per capita, as well as changes to where it is allocated.

Rising unemployment as a result of the pandemic (or any other economic shock) is likely to require increased expenditure on job creation schemes, or on increased out-of-work benefits to the unemployed.

Priorities of government can vary, with objectives changing as new priorities are identified. For example, increased awareness of global warming may result in increased spending on measures to reduce carbon emissions, such as subsidies to encourage people to switch to electric vehicles.

Debt burdens

For those countries with continuous fiscal deficits, debt interest will gradually build up and add to public expenditure, with an increasing proportion of it going on debt interest repayments.

For some countries, this level of debt is unsustainable, meaning that the government is unable able to meet all its current and future repayments without the need for additional loans or defaulting on payments. In some heavily indebted African economies, repaying debt accounts for the largest proportion of public spending.

The significance of public expenditure as a proportion of GDP

Changes in public spending can have wide-ranging effects across an economy, including:

Productivity and growth

Productivity of factors of production – especially labour productivity – can be affected by public spending, although the effect depends largely on how public spending is allocated.

If public spending goes on education and healthcare, then labour is likely to become more productive, firms more efficient, and economies more competitive. Productivity relates to the amount of output generated by a given amount of inputs (factors). Diagrammatically, an economy's long run aggregate supply curve (LRAS) is likely to shift to the right reflecting the increased productivity.

Increasing productivity

On the demand side, an increase in public spending is likely to increase aggregate demand (AD), with the AD curve shifting to the right. [Aggregate demand = C + I + G + (X - M])]

Increasing productivity aggregate demand shifts

If we combine both effects, and make various assumptions regarding where the public spending goes, we can see that both aggregate supply and aggregate demand shift to the right, with a corresponding increase in real GDP.

Increasing productivity

However, if public expenditure does not go on improving education, skills and health, the chances of increasing productivity are much smaller. Many public services are not affected by new technology, and simply hiring more public sector employees may not increase productivity – in fact, it may reduce it.

Living standards

Expenditure by the state can improve the living standards of the population, largely by addressing the market failures associated with the private sector.

There are several areas where public spending can have an impact, including the provision of social housing, welfare transfers, and improving education, health and social care.

Public spending can also go towards public and quasi-public goods which can improve livings standards, such as public spending on amenities like parks, sports leisure complexes, gyms, art galleries and museums. Public money can also go towards subsidising the private sector in delivering such local services, and in improving transport - all of which can improve living standards.

Crowding out

However, public spending can crowd out the private sector – at least according to several economists.

Crowding out refers to the negative impact on private sector firms as the public sector grows.

There are two main types of crowding out, financial and resource:

Financial crowding out

Financial crowding out refers to the fact that when private firms and public bodies need to borrow they will enter the same capital market to do so.

The effect of an increase in the size of the state is to shift the demand for capital to the right, which will have two effects.

Firstly, interest rates are driven up and, secondly, less capital is available for private sector firms.

The impact of a growing state is that, over time, interest rates are driven higher, which may lead to a decline in capital accumulation and ultimately to growth and living standards.

Financial crowding out

Here, without public sector demand for capital, the interest rate for private sector capital would be 'r', with 'i' as the quantity of capital in the economy. If we add the public sector's demand for capital, interest rates are driven up to r1, and demand for private capital contracts from e to e1, with investment by the private sector falling to i1.

Resource crowding out

The second type is resource crowding out, where expansion of the public sector soaks up resources that could have been used for the private sector.

For example, crowding out might occur in the labour market, where an increase in the size of the state is likely to result in an increase in the demand for workers.

This will have two possible effects – firstly, fewer workers are available for the private sector, and, secondly wages may be driven up across the whole economy – increasing costs and resulting in less growth. This has led many economists to argue for controls on the size of the state sector.

This is one reason why international lending by the World Bank and IMF has constraints attached in terms of controlling the size of the public sector in those countries looking to borrow.

Level of taxation

Public spending is also likely to affect the level of taxation in an economy. More spending typically translates into higher tax levels, but this depends on where the spending goes, and whether other sources of public finance are available.

Privatisation, for example, may partly reduce the need for tax rate rises, at least in the short run. While borrowing increases debt it can also be used to fund some government spending - typically capital spending - as long as it is sustainable, it will reduce the need to raise taxes.

Equality

Government spending can be targeted towards the redistribution of income, and ‘leveling up’ the economy.

Spending on social housing, poverty reduction schemes, and free school meals can all reduce the gap between high and low earners.

Education and healthcare spending is one way to reduce relative poverty and increase equality of opportunity.

Conversely, where public spending is allocated towards out-of-work benefits or on capital projects which do not add value (such as 'vanity' projects' of ruling parties) then inequality and poverty may not be affected - at least not positively.

The impact of such expenditure can be seen in a shift of the Lorenz curve, towards the line of perfectly equal distribution of income.

Increasing productivity

The likely impact of an increase in public spending on merit goods

If more public resources are allocated toward the production of merit goods such as education and healthcare several effects are possible:

From a macroeconomic perspective, several effects are possible:

Aggregate demand

The most immediate impact of an increase in such spending is on the demand side, with an injection of spending increasing aggregate demand (AD) for scarce resources. Diagrammatically, this will shift the AD curve to the right.

Increasing aggregate demand - shifts

Output and employment

The impact on output, employment and the price level depends upon the elasticity of short run aggregate supply. The size of the multiplier will also have an impact on the final effect on income and employment.

Aggregate supply

A better educated or healthier workforce will also increase both long run aggregate supply (LRAS) and short run aggregate supply (SRAS).

LRAS shifts to the right because of the increased productive potential from a better educated and healthier workforce.

SRAS will shift to the right because a firm’s average costs of production may fall, perhaps due to less expenditure on cover for sick staff, and less training costs for a more educated workforce.

This will have knock-on implications for national output (Real GDP), more employment from a growing economy, and less pressure on the price level in the long run. This, in turn, may increase the competitiveness of domestic industry, and improve export sales.

Public spending on merit goods

However, it also depends on how the spending is paid for – if taxes are increased there may be a disincentive effect, and if borrowing is required there will be an impact on public sector finances, and the spending may have an inflationary effect.

It also depends on whether the spending is capital or current spending. An increase on expenditure on new health technologies or more computers in schools will have a different effect than spending on doctors’, nurses’ or teachers’ salaries.

Finally, is the expenditure a net increase or is another department of government having less funding available, in which case the overall macroeconomic impact may be smaller.

From a microeconomic perspective, effects may include:

Costs

Assuming a firm's production costs fall as a result of a healthier and better educated workforce (less days lost through sickness, less training costs required), producers may experience an increase in profits. Some of this profit may be distributed to shareholders while other profits are retained to enable the firm to invest in new capital equipment. The effect of the cost reduction can be seen diagrammatically, with a reduction in average and marginal costs. Profits increase from area PABC to area P1KLM

Public spending on merit goods leading to lower costs

Labour market

In terms of a labour market perspective, it is likely that marginal productivity of labour will increase, with a shift to the right in the MRP curve. However, the effect on employment and wages in specific markets will depend upon both the elasticity of demand for and supply of labour.

Public spending on merit goods - impact on labour markets

Externalities

Given the level of positive externalities involved with a healthier and better educated workforce, we can suggest that more public money spent on education and healthcare might push the equilibrium output nearer towards the socially optimum level, as suggested in the following diagram:

Public spending on merit goods - economy moves towards social optimality

Here, the welfare gain from increasing consumption of merit goods beyond the 'free market' quantity would be area a,b,c.

Conclusion

As in all cases, this analysis makes some important assumptions about how spending on merit goods will affect both macro and microeconomic elements in an economy. While the positive case has been presented here, it is not always clear that spending on merit goods will achieve positive results.

The major issues are that spending may take a very long time to have an impact, and that there may be some unintended consequences. For example, when government spends more on education and healthcare there is always the possibility of moral hazard reducing the effectiveness of the spending.